Why the US should enact a VAT

Nearly a year ago I posted on Len Burman’s idea of implementing an add-on value-added tax to fund health care reform, commenting on what a good idea it was to combine tax reform and health reform, because tax reform on its own could probably never be enacted if anything more than revenue neutral. This Thursday I was at a meeting of tax policy experts which included Len, at which he suggested a couple other reasons to like the VAT, besides for the revenue it could raise which we so badly need:

The “announcement effect” would be good stimulus for the recovering but still-weak economy. Policymakers worry this is no time to raise taxes, because the labor market is still weak and thus we still need to be in “stimulus” mode–cutting taxes, if we do anything with taxes. Len explained that of course an add-on VAT would not take effect immediately (heck, let’s face it, it wouldn’t even be enacted any time soon), and as soon as it is clear when the VAT would take effect, the announcement would create the incentive for households and businesses to bring forward in time any consumption they can (such as in durable goods), before the tax takes effect. Later, after the VAT takes effect, consumption may be depressed (and saving encouraged) beyond what would be the normal “steady state” level, which is a fine thing to happen once the economy is at full employment and we’re back to focusing on increasing our productive capacity (rather than just putting to use our existing capacity). Thus, the add-on VAT can be good for both short-term stimulus and longer-term fiscal sustainability.

The intergenerational distribution of the burden of a VAT would work to offset the distributional effects of the federal entitlement programs that disproportionately benefit the elderly. Because a value-added tax is a consumption-based tax, it is economically equivalent to taxing the sum of current labor income plus one’s existing stock of wealth or savings (that’s what can be used to purchase goods and services). Economists like the tax on existing wealth for efficiency reasons, because it amounts to a “lump-sum” tax that doesn’t distort economic behavior (as I explained in my last post on the oil spill and what any fine on BP alone would amount to). On fairness grounds, there was some debate about the desirability of this lump-sum tax on wealth among the tax experts on Thursday. A tax on wealth tends to burden the rich more than the poor, which might seem fair, but it also tends to burden the old more than the young, which might not seem fair–in isolation at least. Tax policy experts have traditionally grappled with this intergenerational burden of consumption taxes in the context of replacing the income tax with a consumption tax–in which case it does seem unfair for a person entering or in retirement, who paid income taxes on his/her labor income over an entire career with the expectation that their income tax burden would go down in retirement (as his/her income would go way down), to suddenly be taxed on his/her consumption (which may remain just as high or higher in retirement compared with in working years). Tax economists have called this a “transition cost” of switching to a consumption tax, and have often concluded that “transition relief” would have to shield the elderly from this tax on existing wealth, which unfortunately would chop the tax base way down and get rid of its most efficient component. But in the case of an add-on VAT, this fairness concern seems less concerning, especially given what the VAT would fund (health benefits that disproportionately benefit the elderly) and why that additional revenue is needed (because existing entitlement programs which disproportionately benefit the elderly are on an unsustainable path). In fact, when this topic was discussed on Thursday, most of the experts seemed to conclude this was an advantage, not a disadvantage, of the VAT (add-on or not)–that it would help alleviate the current intergenerational skewness in the net benefits of federal government programs, as well as which generations (younger ones) bear the burden of the debt.

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